RISK TOLERANCE

More information, including strategies and asset
allocations, is available under our
investment education
section.

Your
choice of fund will also be affected by your
investor profile, which is a combination of factors
- your investment experience, your attitude to
volatility, and your investment time frame.

Below are some examples.

WHAT IS
RISK TOLERANCE?

Have you ever been a passenger
in a car that was being driven too fast?

Or in a car that was being driven too slow?

These questions are about risk tolerance ... but physical
risk tolerance rather than financial risk tolerance.

Research shows that there are four types of risk tolerance:
physical, social, ethical and financial. People behave
consistently within type - a hang-glider is more likely to
also be a mountaineer - but not between types - a confident
public-speaker may or may not be a financial risk-taker.

Here the concern is financial risk tolerance.

Research shows financial risk tolerance to be a single
general attribute relevant to all financial issues. That is,
you do not have one type of risk tolerance when it comes to
investing and another when it comes to borrowing, or career
choices or any of the many other financial aspects of modern
life.

DEFINING
RISK TOLERANCE

Risk tolerance affects how
psychologically receptive an individual is to decisions
involving risk. Thus, decision-making theory is a good place
to seek a meaning for risk tolerance.

Decision-making involves choosing between alternative
courses of action. There is risk in any course of action
where there is no certain outcome. Depending on the
situation, the possible outcomes (for the alternative
courses of action), may be all favourable (a ‘greater good’
choice), all unfavourable (a ‘lesser evil’ choice), or a mix
of favourable and unfavourable.

Drs. Austin Adams and Jim Bright of the Applied Psychology Unit at the University of New South Wales have certified that the FinaMetrica system exceeds internationally accepted psychometric standards.

Click an icon above for your risk tolerance.

Broadly, risk tolerance can be seen as the sum of all the
‘fear/greed’ trade-offs available, including trade-offs
between making the most of opportunities and securing
financial well-being, between regret avoidance over ‘losses’
incurred from taking too much risk, and over ‘gains’ missed
through not taking enough risk, and so on.

Therefore, risk tolerance is best defined as the extent
to which a person chooses to risk experiencing a less
favourable outcome in the pursuit of a more favourable
outcome1.

It is important to recognize that risk tolerance represents
a trade-off on the continuum from minimizing unfavourable
outcomes to maximizing favourable outcomes, not just an
upper limit on unfavourable outcomes. “Risk preference”
would perhaps be a better label for the attribute being
described because “tolerance” has implications that risk is
always an undiluted negative. However, "risk tolerance" is
the term most commonly used.

Most people accept the universal truth of “nothing ventured,
nothing gained.” Risk tolerance is simply a question of
where each individual is psychologically comfortable in
setting the balance point.

Risk tolerance, how much risk I choose to take, is a
psychological attribute of the individual. Risk capacity,
how much risk I can afford to take, is a financial attribute
of the individual’s circumstances.

Risk tolerance affects how psychologically receptive
an individual is to decisions involving risk, and the degree
of anxiety experienced in situations where risk is evident.

Risk capacity is the amount of money an individual
could afford to lose without putting the achievement of
(financial) goals at risk. It represents an absolute,
downside constraint on strategy selection. An individual
should not embark on a course of action where the worst case
scenario involves the possibility, no matter how remote, of
a loss greater than his or her risk capacity.

Risk tolerance and risk capacity both have
important, but distinct, roles to play in the financial
planning process2.

Here, however, we are concerned with risk tolerance.

THE NATURE
OF RISK TOLERANCE

Like many human attributes, an
individual's risk tolerance is thought to be a product of
nature - in essence, what is genetically driven, and
nurture - what has been experienced.

In psychology, it is classed as a psychological trait, i.e.
a relatively enduring way one individual differs from
another.

Risk tolerance is stable but it is not set in concrete. Life
events, good and bad, may have an impact and there is a
general tendency for it to decrease with age.

Relationships with demographic factors have been extensively
studied and some patterns are emerging. In the most
authoritative study3 to date, risk tolerance was found to
be:

•

positively correlated with education, income and
wealth (as these increase, so does risk tolerance
but only slightly) and

•

negatively correlated with age (as age increases
risk tolerance decreases, and at an accelerating
rate) and number of dependents (but again only
slightly.)

Further, there was quite a
large gender difference, with males on average more risk
tolerant than females by comparatively about the same as the
difference between male and female heights. Finally,
marriage decreased risk tolerance marginally.

However, the correlations were all weak or very weak. So,
for example, while 60-year olds are on average less risk
tolerant than 30-year olds, there is quite a reasonable
chance that a particular 60-year old will be more risk
tolerant that a particular 30-year old.

RISK TOLERANCE AND BEHAVIOUR

Risk tolerance will affect
behaviour, but it is only one of a number of factors that
collectively will determine what an individual does in a
particular situation. Other factors will be the perceived
level of risk, the person's goals, the perceived
alternatives and so on.

All other things being
equal, most of us prefer to take paths where the risk is
consistent with our risk tolerance. But, for example, if we
are running late and it is really important to arrive at our
destination on time, we may be prepared to go faster than we
would normally choose.

However there is very real
danger in a situation which you suddenly discover to be far
more risky than you'd thought, as happened to many in the
recent stock market downturn. Lulled into a false sense of
security by smooth travelling of the late 1990s, the bumps
came as a very nasty surprise. If you panic, as some did, it
can be equivalent to jumping out of a moving car.

It is very important that
you understand both the risks and your risk tolerance.